Functions of financial systems

FUNCTIONS OF FINANCIAL SYSTEMS

Financial systems are private and public institutions such as insurance companies, banks, investors, and stock exchanges that allow individuals to exchange funds across mediums. They may also include a set of rules and processes that financial market participants use in deciding which projects to finance, the terms of the deals, and who may fund the projects. These systems may exist within private firms, cities, provinces, territories, or regions. They typically consist of lenders, borrowers, and exchanges that negotiate loans and transactions to fund projects or bring returns on financial assets.

You may organize this type of system with central planning, market principles, or both. Different monetary forms may originate from trading economic goods on both sides. These various forms may include cash, claims on a company, or commodities and depend on the market performance of the asset to increase in value.
The financial system helps determine both the cost and the volume of credit. Consequently, this system can affect a rise in the price of funds, thus adversely affecting the consumption, production, employment, and growth of the economy. Vice-versa, lowering the cost of credit can positively affect and enhance all the above factors. Clearly, a financial system impacts the bare existence of an economy and its citizens.
A financial system is an economic arrangement wherein financial institutions facilitate the transfer of funds and assets between borrowers, lenders, and investors. Its goal is to efficiently distribute economic resources to promote economic growth and generate a return on investment (ROI) for market participants.
The market participants may include investment banks, stock exchanges, insurance companies, individual investors, and other institutions. It functions at corporate, national, and international levels and is governed by various rules dictating the eligibility of participants and the use of funds for different purposes. Aside from financial institutions
A financial system consists of individuals like borrowers and lenders and institutions like banks, stock exchanges, and insurance companies actively involved in the funds and assets transfer.
It gives investors the ability to grow their wealth and assets, thus contributing to economic development.
It serves different purposes in an economy, such as working as payment systems, providing savings options, bringing liquidity to financial markets, and protecting investors from unexpected financial risks.
A specific set of rules drafted under different government policies is required for a stable financial system operating at corporate, national, and international levels.
In any functional economy, economic resources are limited, with individuals having unlimited wants and desires. This problem, referred to as scarcity, is one of the significant drivers of an economy. However, it challenges an economy in determining when, where, to whom to distribute its resources. Consequently, it resulted in a financial system structure capable of efficiently allocating economic resources to stimulate growth.
Financial institutions
are at the core of the financial system, giving individuals the ability to save and invest whenever and wherever they want. Investors put their money in these institutions, which offer them a reward for saving and use it to lend to borrowers. The borrowers can use these funds to build goods and services or fund other projects. All this activity helps promote economic growth
– either by creating additional jobs or generating a profit and contributing back to the economy.

Financial resources are scattered across the economy. This is the reason that there is a need for a financial system that can enable the timely deployment of these resources across different parts of the economy at the right time. A well-functioning financial system is supposed to perform several functions. Some of these functions have been mentioned in this article.

Function #1: Facilitating Payments

The transfer of goods and services can take place smoothly only if there is a mechanism in place to ensure that the payments reach in time. This function is carried out by the payments system. The payment system can be viewed as a subset of the financial system. It is composed of several institutions, such as banks, depository institutions, and private companies.
These institutions pool in their services to provide convenience to users. As a result, users can use different mechanisms like a check, credit cards, and even wire transfers to pay for goods and services. The slow movement of money had been an impediment to trade and commerce for many years. However, now, with the advancement in technology, money can be transferred instantaneously to almost any part of the world.
From the consumer’s point of view, these services appear to be seamless. However, the reality is that for every swipe or check that is issued, a complex settlement process needs to be undertaken. This is why there are special institutions called clearing houses that undertake this process.

Function #2: Transfer of Resources

The cash flow which individuals and companies have sometimes may not match with the cash flow that they desire. For instance, a retired person may have a lump sum of money. However, they may be more interested in a periodic sum of money. On the other hand, a company may want a significant sum of money upfront so that they can invest it in a project. In return, they may be willing to make a series of payments. Both of these tasks are accomplished through the financial system. The financial system allows investors to transform their resources and access it during a point of time that is convenient for them.

Function #3: Risk Management

The derivatives market and the insurance market are an important part of the financial system. These markets have been created with the sole purpose of rationalizing the risk, which is an inevitable part of the life of individuals as well as businesses.
Using the financial system, individuals are able to pool in their resources and cover themselves in case any unforeseen event happens in their lives. In many countries, the government has created a social welfare system. This can also be seen as a system of insurance, which is a part of the larger financial system.

Function #4: Managing Information

The financial system provides important information, which is important for the well-being of the economy as a whole. One of the most important information provided by the markets is about prices. The price information is the basis on which all of the economic theory has been developed. It is the basis on which all economic decisions are made.
For instance, the law of demand as well as supply, both have a price as an important parameter. Hence, traders and other individuals use this information in order to decide the amount they will produce or buy. This means that the economy as a whole also rations its resources based on the price information. This mechanism is extremely important for the economy since it is this mechanism that enables maximum utilization of underlying resources and, therefore, maximum economic growth.
Other prices like interest rates, foreign exchange rates, and even stock prices are important indicators. Individuals can cater to their investment plan based on the information received from the financial system.

Function #5: Efficient Middleman

The financial system plays the role of an efficient middleman. This is because the financial system allows the savings to be diverted towards productive activities with the least amount of transaction costs. The financial system consists of various systems that have been created, keeping in mind the needs of the specific markets. For instance, banks and debt holders based system has been created to fund infrastructure projects which continue over the long term. At the same time, equity-based securities have been created for investors who want to participate directly in the business by taking the associated risks.

Function #6: Pooling of Resources

The financial system makes it possible for a group of investors to achieve what they could not have done individually. For instance, individual investors are limited by their knowledge when they start investing in stocks. However, when a group of investors gets together, the pool of funds becomes so large that they can afford to hire a team of specialists. This enables them to compete with the bigger funds on an equal footing. The ability to pool resources and deploy them safely is the hallmark of any financial system. All major financial systems and services like banking, insurance, and even mutual funds are the result of the proper discharge of this function.
Therefore, it would be appropriate to say that financial systems perform a lot of functions that can be considered fundamental. If these functions are not discharged, the markets, as we know today would not exist.
Functions of a financial system
Some functions of these fiscal systems include:
Ensure liquidity
For individuals and institutions to run asset and fund transfers, enough asset liquidity is necessary to match demand. The financial institutions, markets, and service providers involved in these systems ensure a fluid flow of funds so investors can buy and sell assets at will and make these assets easily accessible. Liquidity also contributes to the system's stability and can make it less prone to financial crises or collapse.
Create a payment system
Financial institutions and service providers within a fiscal system provide a payment system for individuals. They create an efficient and seamless process that allows merchants and businesses to send and receive money in exchange for products and services. Additionally, they enable individuals to access cash regardless of location. Through this system, individuals can make payments with credit cards, checks, or cash.

Modern-day economies require vast sums of money to invest in capital assets (land, equipment, factory, etc.), which are then used to provide goods and services. The funds required are so huge that a single government/firm can't meet the requirement. However, by selling financial claims like stocks, bonds, etc., various investors can quickly raise the required funds. The business firm/government issuing such a monetary claim hopes to return the borrowed funds from expected future inflows. Indeed, we see that the financial markets within the financial system have made possible the exchange of current income for future income and the transformation of savings into investments so that production and revenue keep growing.

Following are the features characteristics of financial system :
Financial system establishes a link between the one having surplus funds with those who are in need of such funds. Both the investment and the savings aspects are encouraged,
Financial system contributes towards the expansion and the development of financial markets.
Financial system facilitates the efficient allocation of financial resources for the benefit of the society and the public at large.
Financial system boasts the economic quality and accelerates economic development.
Financial system lays the foundation for an ideal economy.
Financial system builds an efficient portfolio for the fund seeker.
Financial system reduces the transaction costs.
Financial system ensures availability of all the price-related information.
Financial system helps in channelizing the savings in an effective manner to reap the best possible outcome. The resources are allocated in such a manner that there is a regular advancement in technology and sustained growth can be achieved.